Analytics

Monday, May 9, 2011

The Public Utility

Hey campers,

I'd like to take some time to talk about my favorite investment: The public utility. Public utilities are what I would consider the best example of an investment over a speculation. So, before I start to preach the benefits of a public utility investment, let me first discuss how they are structured and what they are.

A public utility is a company that provides a "necessary service" to a geographic location. An example of a public utility is Con Edison, which provides electricity in New York City. Most public utilities (I think around 70%, don't quote me on that) are providers of electricity, while the rest provide things like gas, water, and so forth. What distinguishes a public utility from any other company is the following:

1. A defined geographic location in which they have significant infrastructure designed to deliver to said location.

2. They are heavily regulated and are required to deliver their service for a price that is in line with other public utilities.

3. They are the sole provider of service to the area.

So what is it about the (relatively boring) public utility sector that has me so excited?

Well, first off, a public utility is the definition of a monopoly. And if you'll recall from my previous posts, I love monopolies as an investment. The moat of competitive advantage that we look for in a firm is not only present in public utilities, it has been dug out and filled with water (and alligators!) by the government itself! They have guaranteed customers! There is no possibility to compete with them! The regulations which are intended to protect consumers actually protect the utilities themselves from being taken down. This is readily apparent if we look at the Dow Jones Industrial Average and compare it to the Dow Jones Utilities Average.

It is first worth noting that the DJIA has experienced significantly higher appreciation than the DJUA. This could indicate to an investor that he would find better returns in the DJIA. I suspect this has influenced investors over the past hundred years and has led them to favor industrials over utilities.

However, there is a distortion here which is often unaccounted for, and given the time frame of the two indices it leads up to some glaring contrasts in the index's performance as compared to an investor's performance. The first I would like to mention is the issue of dividends. Growth in companies is already priced in in a compounding sort of way (the companies effectively do this for us by retaining and reinvesting their earnings). This means that the plowback (that is, earnings not paid out in dividends) is compounded as well. The dividends, however, are not compounded in any way--and how would they be? There is no way to know what an investor does with his dividends. A public utility investor could reinvest his dividends and his funds experience a compounded level of growth not made readily apparent by the DJUI. Over a few year horizon, the difference negligible at best, but when we begin to compare over a 90 - 100 year investment horizon, the difference is night and day. Long story short, the DJIA enjoys internal compounding, where the DJUA does not.

Furthermore, an investor would be wise to notice that there is only one company of the original 12 which remains in the DJIA! (General Electric). Had an investor invested in all 12 of the original Dow Jones Industrial Average companies, they would have witnessed many of their investments turning sour as the companies were destroyed by competitors. To get decent performance they would have to buy and sell many different companies throughout the past century to mirror the success of the DJIA.

Here is the real reason to invest in a public utility company: And keep this in mind, because it is a big one. Despite having over 100 different changes to the Dow Jones Industrial Average over the past century, the DJUA has remained, in essence, unaltered. There have been mergers, but that's it. That is how bullet proof these companies are--how strong their competitive advantage is, how deep their moats are.

There is a quote by Robert Schuller, "What would you attempt to do if you knew you would not fail?" I would like to modify it slightly to fit this circumstance: "How would you invest in a company if you knew the company could not fail?" I'm not saying its impossible for these public utility companies to fail. However, the likelihood of their failure is significantly reduced over that of a industrial stock. I would like you to ponder that question: how would you invest in a company if you knew the company couldn't fail. Let me give you my answer.

I would use the market oscillations of the price to my advantage. As the price dropped, I would always buy more. I would never get rid of the company and I would collect the profits in the form of dividends-- which brings us to my next point:

The dividends!

If you followed the link to examine Con Edison on Yahoo! Finance, you may have noticed that the dividend yield is a relatively attractive 4.90%. Well, this is the flip side of public utility investment: because these companies are restricted by the geographic location of where they can function, they cannot do very much with their profits in terms of company reinvestment for growth. Consequently, most public utilities dividend off most of their earnings to their investors. This allows a public utility investor to look at himself more like a small business investor: he buys the utility, he collects a certain return, and can do what he will with the profits. The relative simplicity of a public utility investment adds to its attractiveness. Public utilities do not have convoluted financial statements to rummage through, they do not switch gears and try to break into new markets. They do the same they have done for the past 100 years, and they will likely do the same thing for the next 100 years. There is little speculation required to guess where public utilities are going.

Now, if you are a bit savvy (and I know that you are, brilliant reader!) you may begin to see a parallel between investing in a public utility and investing in bonds. I agree with you, of course, there are some significant similarities. The predictability of the earnings and dividends are similar to the predictability of the coupon payments, and there is little growth to be achieved through capital gains. And yet, a public utility is allowed to raise its prices in response to inflation, while a bond remains fixed. In this way, a public utility overcomes one of the unfortunate flaws that bond investors suffer--keeping up with inflation!

I am going to wrap this up because I think I have driven my points home laboriously enough, and if I continue to preach the benefits of public utility investing you all may start to believe I have been hired by a consortium of public utilities. But consider this: Many people think that to become wealthy by investing in stocks, you have to jump in and out, or find the right ones, or maneuver like some sort of half-genius, have sorcerer. Yet, if you set aside a bit of money each money and plunked it down into a public utility with a 5-6% dividend yield, reinvesting the dividends until you need the income, you too could have a pretty nice nest egg in 30 - 40 years to retire on. No genius required, no jumping about, no intense security analysis required. Because public utilities do not need a savvy business eye to know that their competitive advantage is strong, all they need in terms of security analysis is someone vigilant to make sure their financing is kept to reasonable levels. Public utilities are the dream stock for an accounting-oriented fundamental investor. And keep in mind, for all the brilliance people bestow upon Warren Buffett, and for all the clever and unusual methods he occasionally attributes to his success, 50% of Berkshire Hathaway's income comes from public utilities and insurance companies. FIFTY percent! If it's good enough for Buffett to rely on the vast majority of his income for, there may be something to these under-appreciated wonders.